The IRS cautions plan administrators that they must document and keep necessary records of all employees' hardship distributions and plan loans. The result of noncompliance could be a qualification failure for the plan.
Basic information. In general, a retirement plan can make a hardship distribution only:
- If the plan permits such distributions; and
- Because of an immediate and heavy financial need of the employee. In this case, the distribution should only be an amount necessary to meet the financial need.
Hardship distributions are generally subject to income tax in the year of distribution. And, if the employee is under age 59 1/2, the distribution is subject to the 10 percent early distribution tax unless some exception to this early distribution tax applies. However, hardship distributions aren't subject to mandatory 20 percent income tax withholding.
In general, the question of whether an employee has an immediate and heavy financial need is based on the relevant facts and circumstances. Under IRS regulations, a distribution is treated as made on account of an immediate and heavy financial need if it is made for:
- Expenses for (or necessary to obtain) medical care that would be deductible under tax law, including expenses for the care of a spouse or dependent.
- Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments).
- Payment of tuition, related education fees, and room and board expenses, for up to the next 12 months of post-secondary education for the employee, the employee's spouse, children or dependents.
- Payments necessary to prevent the employee's eviction from a principal residence or foreclosure on the mortgage on the residence.
- Payments for burial or funeral expenses for the employee's deceased parent, spouse, children or dependents.
- Expenses for the repair of damage to the employee's principal residence that would qualify for the casualty tax deduction.
Under IRS guidance, a 401(k) plan that permits hardship distributions of elective contributions to a participant only for expenses described above may permit distributions for medical, tuition and funeral expenses for a primary beneficiary under the plan. A "primary beneficiary" is someone named as a beneficiary under the plan who has an unconditional right to all (or part) of the participant's account balance upon the participant's death.
A distribution won't be treated as necessary to satisfy an employee's immediate and heavy financial need to the extent it exceeds the amount required to relieve that need, or the need can be satisfied from other resources that are reasonably available to the employee.
Unless an employer has actual knowledge to the contrary, it may rely on an employee's written representation that his or her immediate and heavy financial need can't reasonably be relieved:
- Through reimbursement or compensation by insurance or otherwise;
- By liquidating assets;
- By stopping elective contributions or employee plan contributions; or
- By other distributions or nontaxable loans from employer plans or by any other employer, or by borrowing from commercial sources on reasonable commercial terms.
A hardship distribution can't exceed the "maximum distributable amount." In general, this amount includes the employee's total elective contributions on the distribution date, reduced by any previous distributions of elective contributions.
Get and Keep Records
In its Employee Plans News, the IRS states that failure to have hardship distribution records available for examination is a qualification failure that should be corrected using the Employee Plans Compliance Resolution System (EPCRS).
The IRS tells plan sponsors to retain the following records in paper or electronic format:
- Documentation of the hardship request, review and approval;
- Financial information and documentation that substantiates the employee's immediate, heavy financial need;
- Documentation to support that the hardship distribution was properly made in accordance with the applicable plan provisions and the Internal Revenue Code; and
- Proof of the actual distribution made and related Forms 1099-R.
It's not enough for plan participants to keep their own hardship distribution records, the IRS cautions, because they may leave employment or fail to keep copies of documentation, which would make their records inaccessible in an IRS audit.
Also, electronic self-certification is not sufficient documentation of the nature of a participant's hardship. IRS audits show that some third-party plan administrators allow participants to electronically self-certify that they satisfy the criteria to receive a hardship distribution. While self-certification is permitted to show that a distribution was the sole way to alleviate a hardship, the IRS reminds plan sponsors that self-certification is not allowed to show the nature of a hardship. Plan sponsors must request and retain additional documentation to show the nature of the hardship.
Basic information. A loan to a participant in a qualified employer plan won't be treated as a deemed (taxable) distribution if it satisfies certain amounts, terms, repayment and documentation requirements. A plan loan amount can't exceed the lesser of: $50,000, or one-half of the present value of the employee's nonforfeitable accrued benefit under the plan.
But a loan up to $10,000 is allowed, even if it's more than half the employee's accrued benefit.
If a plan loan (when added to the employee's outstanding balance of all other plan loans) exceeds these limits, the excess is treated (and taxed) as a plan distribution.
A participant may have more than one outstanding plan loan at a time. However, any new loan, when added to the outstanding balance of all of the participant's plan loans, can't exceed the plan maximum amount.
In determining the plan maximum amount, the $50,000 ceiling is reduced by the difference between the highest outstanding balance of all the participant's loans during the 12-month period ending on the day before the new loan and the outstanding balance of the participant's loans from the plan on the new loan date.
A plan loan generally must be repaid within five years in substantially level payments, made not less frequently than quarterly, over the term of the loan. The five-year repayment limit doesn't apply to a loan used to buy a dwelling unit which, within a reasonable amount of time, is to be used as the participant's principal residence. In general, refinancing can't qualify as a principal residence plan loan. The plan loan must be evidenced by a legally enforceable written agreement with terms that demonstrate compliance with the requirements for nondistribution treatment, specifying the amount and date of the loan, and the repayment schedule.
What to Keep
The IRS tells plan sponsors to retain the following records, in paper or electronic format, for each plan loan granted to a participant:
- Evidence of the loan application, review and approval process;
- An executed plan loan note;
- If applicable, documentation verifying that the loan proceeds were used to purchase or construct a primary residence;
- Evidence of loan repayments; and
- Evidence of collection activities associated with loans in default and the related Forms 1099-R, if applicable.
If a participant asks for a loan with a repayment period in excess of five years to buy or build a primary residence, the plan sponsor must obtain documentation of the home purchase before the loan is approved. IRS audits have found that some plan administrators impermissibly allowed participants to self-certify eligibility for these loans.